Prudential stress testing in financial networks

Mikhail Oet, Ivana Ruffini, Kimmo Soramäki and Tuomas Takko

Prudential stress testing in financial networks is important because it gives organisations insight and knowledge about unobservable sources and critical means of controlling systemic risk that is otherwise not known to them. Key sources of unobservable systemic risk include the indirect network effects of the behaviour and choices of people and institutions and the markets they operate in. These can be measured by understanding their interconnectedness from structured and unstructured data sets. The key elements of control are the mechanisms by which systemic effects manifest in financial networks: default contagion, distress contagion, common assets contagion and funding liquidity contagion. The key types of prudential questions that organisations can answer shed light on perturbations in networks centering on microprudential (organisational) and macroprudential (systemic) risks.

Microprudential stress testing addresses risk from credit, operational, market or liquidity activities. Macroprudential stress testing addresses risks from systemic imbalances in risk, credit, operational, market, interest-rate, liquidity and structure concentrations, connectivity and contagion